U.S. oil and gas producers will likely increase their capital spending by less than the rate of inflation in 2022, providing the fuel for another year of outsized gains for producers' stocks as investors rediscover the sector.
Capital spending by U.S. exploration and production companies, or E&Ps — a list dominated by big independent shale oil and gas companies — is expected to increase 4.7% in 2022, S&P Global Market Intelligence data showed Jan. 14. According to the estimates of analysts surveyed by Market Intelligence, the net debt of the companies in the S&P Oil & Gas Exploration & Production Index will have been cut nearly in half — by more than $100 billion — between 2020 and the end of this year.
Oil and gas drillers kept spending flat over the past year as commodity prices rose, giving them extra cash to reduce debt while paying back shareholders. That discipline convinced investors that the industry could become a stingy steward of capital despite its history of spending big on production growth, analysts said.
"Talk is cheap, especially considering E&Ps' lengthy track record of capital (mis)management, and investors wanted results," Raymond James & Associates oil and gas analyst John Freeman said Jan. 10. "Not only have E&Ps kept their word, they surpassed all expectations."
"Reinvestment rates, currently at historic lows, have led to record profitability," Freeman said. "E&P free cashflow yields, something unknown to the sector just ~5 years ago, are now the highest in the market. Even shareholder returns, previously thought to be extinct in the E&P sector, are commonplace among nearly every company within our coverage."
Other analysts also saw the change in the industry. "There is little desire to go back to the days of growth at any cost, nor would investors tolerate such an outcome," James Mick, managing director and senior portfolio manager with energy investment firm TortoiseEcofin, said Jan. 10.
At Goldman Sachs' 2022 Global Energy Conference in the first week of January, oil and gas producers "talked about capital allocation, maximizing return on invested capital and a laser focus on controlling costs," Mick said.
The industry's habit of chasing higher prices by drilling new wells appears to be gone, at least for now, Truist Securities Inc. oil and gas analyst Neal Dingmann said. The habit has been "replaced by the desire to generate ample free cash flow and pay out shareholder returns," Dingmann said. "Our companies now also have some of the best balance sheets in years, with the average E&P having current leverage just over 0.5x [net debt/EBITDA]. The strong financials that are likely to only improve in the near term provide numerous options not available to companies in the past."
With share values rising quickly, one of the options for companies is to use shares to acquire other entities in all-stock deals done without debt, analysts said, making 2022 ripe for more mergers and acquisitions.
"The energy sector has undergone a massive wave of consolidation over the past 18 months, and deals have been overwhelmingly equity funded, which we expect to continue," senior analysts Jake Leiby and Charles Johnston with credit research firm CreditSights Inc. said Jan 12. "We expect credit-friendly consolidation among the E&Ps to continue as companies look to reap benefits including lower costs, greater scale, operating efficiencies (larger acreage blocks), and greater access to capital."
Reducing investment in production growth could have long-term consequences for drillers, Center for Strategic and International Studies senior fellow Ben Cahill cautioned. "Underpinning this profitability ... is an unsustainable level of investment," Cahill said. "Initial production rates at wells usually drop off quickly, so companies need to drill continuously to sustain output. They can only pull back on investment for so long without sacrificing future production levels and cash generation."